Taking a lump sum out of your pension could provide you with more financial freedom. Yet, it could also land you with a large and unexpected tax bill.

Read on to find out what you need to know about tax and withdrawing lump sums from your pension.

Your pension withdrawals may be liable for Income Tax

You can take up to 25% (up to a maximum of £268,275 in 2024/25) of your pension tax-free. You can choose to access this tax-free portion as a single withdrawal, or spread this entitlement across multiple withdrawals throughout retirement, with a portion of each being tax-free.

However, the other 75% of your pension will usually be classed as income when you access it. So, if the total amount you withdraw in a single tax year exceeds the Personal Allowance, which is £12,570 in 2024/25, it could become liable for Income Tax.

Withdrawing large lump sums could mean you face an unforeseen tax bill or lead to you paying more in tax than you would if you spread out withdrawals.

You should note that pension withdrawals will be added to your other income when calculating your Income Tax bill. As a result, you might also need to consider the money you receive from employment, the State Pension, or interest on savings when working out how much tax you’ll pay.

Let’s say you hold £100,000 in your pension and you want to withdraw all the money from it as a single lump sum. Assuming you didn’t have any other sources of income in 2024/25, then:

• £25,000 would be tax-free
• £12,570 would fall into your Personal Allowance and wouldn’t be liable for Income Tax
• £37,700 would fall into the basic-rate tax bracket and be taxed at a rate of 20%
• £24,730 would fall into the higher-rate tax bracket and be taxed at a rate of 40%.

In this scenario, that could lead to an Income Tax bill of £17,432. That’s a sizeable portion of your pension that’s going to HMRC.

Research from Standard Life indicates that pension holders could be unwittingly making withdrawals that lead to large tax bills.

Indeed, between October 2022 and March 2023, 221 people fully withdrew a pension worth £250,000 or more, which could lead to a tax bill of at least £97,500 each. Similarly, more than 1,500 savers fully encashed pensions worth between £100,000 and £249,000 during the same period.

Further data published in FTAdviser suggests that half a million pensions were emptied the first time they were accessed in 2022/23. The general election campaign and Labour’s subsequent victory also reportedly led to more savers draining their pensions due to fears about proposed taxes.

While there might be good reasons to fully withdraw your pension, understanding the tax implications could help you decide if it’s the right decision for you.

Managing pension withdrawals across several tax years could reduce your overall tax bill. As your Personal Allowance resets each tax year, you’d access a greater portion of your pension tax-free, and it might help you avoid paying the higher or additional rate of Income Tax.

2 insightful questions to consider before taking a lump sum from your pension

1. What’s behind your decision to withdraw a lump sum from your pension?

Before you take a lump sum from your pension, consider what you’ll use the money for – could you use other assets to cover your plans that would result in a lower tax bill?

If you don’t have plans to use the money, examine the motivation behind your decision. In some cases, emotions and bias may be harming your decision-making.

For example, the FTAdviser research indicates that some savers have responded to concerns that the Labour Party could make changes that will affect their pension.

Fear might play a role in other ways too – you may be worried about the investment risk your pension is exposed to and feel that holding your money in cash is “safer”. However, as inflation is often higher than the rate of interest a savings account offers, taking your pension to hold in a cash account could erode its value in the long term.

2. How will withdrawing a lump sum affect your long-term financial security?

As well as understanding the tax bill, you may want to consider how withdrawing a large part of your pension could affect your retirement income in the future.

Reducing the value of your pension by taking a lump sum could mean you’re at risk of running out of money in your later years. In addition, withdrawing a lump sum could affect the expected returns your pension will deliver throughout retirement.

It could be sensible to take some time and calculate the potential long-term effects of taking a lump sum from your fund. This could highlight where you could be placing your long-term security at risk, or give you more confidence to proceed. A financial plan could help you visualise how taking a lump sum from your pension might affect your future so you can understand which option is right for you.

We could help you cut your tax bill

Working with us to create a holistic financial plan could help you identify ways to reduce your overall tax bill. We’ll work with you to understand your income needs and assets, and build a plan for accessing your pension that could minimise the amount of tax you pay.

To talk to us about your pension and tax liability, please get in touch.

Please note:

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.

The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.

Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

The Financial Conduct Authority does not regulate tax planning.